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Do Ex-Dividend Drop-Offs Differ Across Markets? Evidence from Internationally Traded (ADR) Stocks

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Do Ex-Dividend Drop-Offs Differ Across Markets? Evidence from Internationally Traded (ADR) Stocks SCHOOL OF FINANCE AND ECONOMICS UTS:BUSINESS WORKING PAPER NO. 92 OCTOBER, 1999 Do Ex-Dividend Drop-Offs Differ Across Markets? Evidence from Internationally Traded (ADR) Stocks V.T. Alaganar Graham Partington Max Stevenson ISSN: 1036-7373 http://www.business.uts.edu.au/finance/ Do Ex-dividend Drop-offs Differ Across Markets? Evidence From Internationally Traded (ADR) Stocks V.T. Alaganar, G. H. Partington and M. Stevenson The authors are from the School of Finance and Economics University of Technology-Sydney, Australia Abstract This paper investigates whether the ex-dividend drop-offs for ADRs differ from the ex-dividend drop-offs of their underlying Australian stocks. An expected source of difference in the valuation of dividends, and hence in the drop-offs, is the availability of imputation tax credits to Australian resident investors. Valuation differences across markets present an arbitrage opportunity, but we hypothesize that transaction costs and risk will inhibit arbitrage and that the valuation difference will persist. Our results are consistent with this hypothesis. The ADRs have lower drop-offs and behave more like stocks taxed under a classical system than the underlying Australian stocks. JEL Classification Codes: G12, G15, G35 Keywords: Ex-dividend, ADR, Drop-off ratio, imputation tax, arbitrage Address for correspondence: Dr. V.T. Alaganar School of Finance and Economics, University of Technology Sydney, P.O. Box 123 Broadway, NSW 2007, Australia [email protected] Fax: 61-2-9514-7711 Phone: 61-2-9514-7732 Do Ex-dividend Drop-offs Differ Across Markets? 2 Evidence From Internationally Traded (ADR) Stocks 1. Introduction The purpose of this paper is to determine whether, for internationally traded stocks, the ex- dividend price drop differs between the domestic market1 and the overseas market. This investigation has relevance for several research questions. For example, do domestic tax arrangements affect the prices of internationally traded stocks, or are international capital markets so well integrated that arbitrage trades equalize the drop-off ratios? Our analysis involves Australian stocks traded domestically and traded in the United States as American Depositary2 Receipts (ADRs). An interesting feature of this analysis is that Australian stocks are taxed under a full imputation system. Under this system, resident Australian investors (domestic investors) are able to recover all the corporate tax paid on dividends via a system of tax credits. These credits are known as imputation tax credits, or franking credits. We examine whether imputation tax credits make Australian dividends more valuable to domestic shareholders, than to international shareholders holding ADRs. This is accomplished by comparing ex-dividend day drop-off ratios3 for the domestically traded stock and the ADR. We find these drop-off ratios differ. Our results suggest that the ex-day drop-off ratios for ADRs 1 The term domestic market refers to the country of the home exchange for the underlying stock. In this case, the Australian market. 2 Two spellings are possible for depositary. The alternative is depository, but depositary is favored by the depositary banks. 3 The drop-off ratio is a standard statistic used to compare drop-offs across companies. It is defined as the ex-dividend price drop divided by the dividend. 3 behave more like stocks taxed under a classical tax system, than the underlying Australian stocks.4 The Australian stocks have a higher drop-off ratio than the ADRs. There are three implications that arise from this result. First, that imputation credits have value to Australian investors, but little or no value to overseas ADR investors. Second, that there are barriers (transactions cost and risks) to international dividend stripping which, for example, prevent arbitrageurs buying dividends in the ADR market in which the dividends have a lower price. Third, legal restrictions on trading imputation credits, and the cost of circumventing those restrictions, have an effect on the value of dividends. If imputation credits could be freely traded their value should be fully reflected in the ADR drop-off. Our results suggest that domestic tax arrangements do affect the pricing of internationally traded stocks on the ex-dividend date and, in this respect, international capital markets are not fully integrated. This paper is organized as follows. A description of the ADR market is presented in the next section (Section 1). Differences between the Australian and U.S. equity markets, which are important for this study, are also included in Section 1. In Section 2 we develop our hypothesis, which arises from a discussion of research related to ADRs and to Australian and U.S. ex- dividend price behavior. Data and data sources are discussed in Section 3. Results are presented in Section 4, while Section 5 contains concluding remarks. 4 This behavior is similar to the behavior of Australian stocks that pay dividends without any imputation tax credits. 4 1.1. ADRs and the Differences between Markets A depositary receipt is a negotiable receipt representing equity in a non-U.S. company. A depositary bank in the U.S. issues ADRs, and each ADR is backed by a fixed number of underlying shares in the custody of a bank (called the custodian bank) in the domestic market. The depositary bank carries out the responsibilities with respect to the payment of dividends and shareholder voting as stated in the ADR agreement. The objective in creating the ADR is to reproduce the same rights and benefits for the ADR holders as they would obtain by holding the underlying stock. The sponsored ADRs that we study are treated in the same manner as other U.S. securities for legal and administrative purposes. They can be listed on any of the U.S. exchanges, and they must meet US disclosure requirements. Attributes of ADRs relevant to this study are (a) lower transaction costs and execution risks compared to direct purchase in the overseas market and (b) pricing is in US dollars and dividend payments are made in US dollars. Trading of ADRs is simplified by the ability to transfer ownership in the books of the depositary bank. The supply of an ADR is not fixed, and can be changed by the actions of investors. For example, an investor can either purchase existing ADRs in the U.S., or purchase underlying shares in the domestic market and have new ADRs issued by the depositary bank in exchange for depositing the shares. The reverse trade called 'flowback' occurs when ADRs are cancelled in the U.S. and the underlying shares are released in the domestic market. Trading within the U.S. market accounts for the bulk of ADR trading volume but there is a small quantity of inter-market trades.5 These inter-market trades result in the number of available ADRs changing as investors attempt to exploit arbitrage opportunities between the markets. One important distinction between the underlying stock and the ADR is that one ADR is not necessarily equal to one underlying share. The custodial bank will bundle the underlying shares into a package that will trade in a price range broadly comparable with shares traded in the U.S. market. The ADR can therefore represent more or less than one share of the underlying stock. The number of shares of stock represented by the ADR is known as the conversion ratio. In the case of Australian stocks, the conversion ratio is generally greater than one. 1.1.1. Difference in Taxes between Markets A major difference between the Australian and U.S. equity markets is in the tax regimes that they operate under. The U.S. operates a classical tax system in which taxes are levied on corporate profits and shareholders also pay taxes on dividends distributed from those profits. In contrast, Australia operates a full imputation system. From the point of view of an Australian resident, only personal tax is paid on corporate income distributed as dividends. The system works as follows. Suppose an investor with a tax rate, td, receives a dividend, D, distributed from profits fully taxed at the corporate tax rate, tc. The investor’s income tax liability is calculated by grossing up the dividend to the equivalent share of pre-tax corporate income, and tax is assessed on that amount. Thus the investor’s tax liability is given by (D/1-tc)td. However, the investor also receives an imputation tax credit known as a franking credit. The franking credit is the full amount of corporate tax paid on the dividend received, which is given by (D/1-tc)tc. Thus the tax the investor actually pays is given by (D/1-tc)(td - tc). Investors with a personal tax rate above the corporate rate will, therefore, have some extra tax to pay, while investors with a personal tax rate 5 According to the Bank of New York (http://www.bankofny.com/adr/) about 95 % of the ADR trading is within the US market and about five percent is intermarket trading. 5 less than the corporate rate will have a surplus credit. The surplus credit can be used to offset tax on other income. It is not legal to buy and sell imputation credits. Not all of a company’s income may have been subject to Australian corporate tax, in which case a tax credit is only available to the extent of company tax paid. Under these circumstances, dividends are labeled partially franked. This distinguishes them from fully franked dividends where company profits have been fully taxed. With one exception non-resident investors do not benefit from the franking credit. The exception is in regard to withholding tax. Dividends paid to investors outside Australia are subject to a withholding tax. This tax is 15 % in the case of U.S.
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